Short Selling Stock: How It Works And Why We Desperately Need It

I often have a hard time trying to explain how short selling stock works and more importantly, why we need it to keep the market alive. Now I understand completely the biggest hurdle that people have to overcome when we talk about short selling stock and it's the ability to sell something you don’t own yet.

But all too often short sellers get a bad wrap from the main street investing community when in fact short sellers are vital role to keeping the markets moving and efficient.

What Is It & How Does It Work?

Let me put this into very simple terms. You've heard the adage "buy low and sell high" right? Short selling is the exact opposite of that. You first sell the stock at a high price and later buy back the shares at a low price. The part that gets people confused is that the trader doesn’t own the shares they sell.

If you don't own the shares then how can you sell them right? Here's how you do it. You have to borrower the shares from your broker and immediately sell the shares in the open market. Since you borrowed the shares you now have an obligation to deliver them back to the broker at some time in the future.

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Just Like Any Other Obligation

As with anything in life, if you borrower something you have to eventually pay it back. In stock trading, you do this by repurchasing shares in the market and delivering those shares back to the broker. Prior to entering any short sale trade though you must be approved for margin trading with your broker.

The goal of a short seller is to purchase the shares back in the market for a lower price in the future and net a profit. Again think "sell high and buy low" this time. If the opposite happens then you lose money (you sell the shares and have to repurchase them at a higher price down the road).

Don't Crucify Short Sellers!

In the media, short sellers are getting a lot of attention and are seen as "betting on stocks to fail" when in reality they are simply making educated decisions about investments. Just like a long trader will buy undervalued shares in hopes of a rising price in the future, so too will a short seller look for overvalued companies that might go through a correction.

Short sellers are never directly responsible for these rapid market moves downward. If people keep buying stock then the markets will always continue to move higher - it's just that simple. In reality, short sellers keep the market efficient by providing higher levels of liquidity at times when other investors are on the sidelines.

About The Author

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor.
He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.